There are many
reasons for the wide popularity of 401(k) plans, one of which is that they
shift the funding burden from employers to employees. But this advantage may
be diminished for plans classified as "top heavy" where special contribution
rules kick in that plan sponsors may not be aware of. What follows is a
detailed look at the impact of the top heavy rules on 401(k) plans and some
strategies for minimizing the cost to employers.
What is a Top Heavy Plan?
A defined contribution plan is considered top heavy when more than 60% of
the account balances are attributable to "key employees." A key employee is
an employee who meets any of the following criteria during the determination
year:
- Owns more than 5% of the employer;
- Owns more than 1% of the employer and had compensation in excess of
$150,000; or
- Is an officer of the employer with compensation in excess of a
specified dollar amount ($165,000 for 2012), with certain limits on the
maximum number in this category.
In determining ownership, family attribution rules apply, meaning that an
employee is deemed to own the stock or interest owned by his or her spouse,
parents, children and grandchildren. It's important for employers to keep
their third party administrators abreast of any changes in the ownership or
officer status of the company so that the top heavy tests can be performed
accurately.
The term "key employee" is sometimes confused with "highly compensated
employee" (HCE) which is used for nondiscrimination testing. The main
difference is that HCEs include all employees earning more than a certain
dollar amount in the prior year ($115,000 in 2012), whereas such employees
would not be considered key employees unless they meet the ownership or
officer criteria.
Most large 401(k) plans are not top heavy due to the high number of
non-key employees participating.
How is Top Heavy Calculated?
For ongoing plans, the top heavy determination date is the last day of
the preceding plan year (determination year). For new plans, the
determination date is the last day of the first plan year. As of the
determination date, the account balances, including loans, of the key
employees are compared to the total account balances of all participants,
without regard to the plan's vesting schedule. Certain adjustments must be
made to the account balances when performing these calculations. The
following amounts must be added: distributions to recent terminees;
in-service distributions over the past five years; and the cash surrender
values of whole life insurance policies.
The following amounts must be subtracted: unrelated rollovers, i.e.,
those not coming from another plan sponsored by the same employer (related
rollovers should not be deducted); and account balances of participants who
terminated prior to the determination year. Account balances and
distributions to former key employees are not included.
Here is an example of a top heavy plan calculation: Thomas owns 100% of
ABC Company which sponsors a profit sharing plan. He and his wife both work
for the company as does their 25 year old son. All three are considered key
employees due to stock ownership and attribution rules. The account balances
under the plan are as follows:
| Thomas |
$500,000 |
|
|
|
| Cindy |
100,000 |
|
|
|
| Thomas, Jr. |
50,000 |
($25,000) |
|
|
| Total Key |
$650,000 |
($25,000) |
|
$625,000 |
| Non-Key |
450,000 |
(100,000) |
$25,000 |
375,000 |
| Plan Totals |
$1,100,000 |
($125,000) |
$25,000 |
$1,000,000 |
|
Key Percentage: |
62.50% |
Since the adjusted account balances of the key employees exceed 60% of
the adjusted account balances of the entire plan as of December 31, 2011,
the plan is top heavy for 2012.
Generally, if the employer sponsors multiple plans covering the same key
employee(s), they are required to be aggregated for top heavy purposes.
Consequences of Being Top Heavy
A defined contribution plan that is top heavy must provide a minimum
contribution to non-key employees equal to the highest contribution rate
allocated to any key employee up to a maximum of 3% of compensation. For
example, if a top heavy profit sharing plan has one key employee who
received a contribution of 2% of his compensation, then all non-key
employees would be entitled to a 2% contribution. If the key employee
receives a 4% contribution under the plan formula, then the non-key
employees must receive at least a 3% contribution.
Forfeiture allocations, as well as matching contributions in a 401(k)
plan, are included and provide a dollar-for-dollar offset of the required
top heavy contribution. When an employer sponsors multiple plans, the top
heavy benefits need only be provided by one of the plans; however, there are
special rules and potentially higher contributions that may apply when an
employer sponsors both a defined benefit and defined contribution plan.
Impact on 401(k) Plans
The top heavy regulations provide that salary deferrals made by key
employees are considered employer contributions but deferrals by non-key
employees are considered employee contributions. In other words, deferrals
by a key employee can trigger the top heavy contribution requirement, yet
deferrals by a non-key employee cannot be used to satisfy the requirement.
For example, if the plan is top heavy and one key employee defers 4%, the
3% minimum contribution requirement will apply to all non-key employees who
have met the plan's eligibility requirements, even those who have elected
not to make deferrals. It is important to note that for plans with multiple
eligibility schedules, i.e., immediate eligibility for 401(k) deferrals and
a one-year wait for company contributions, any non-key employee who is
eligible for any component of the plan and is still employed on the last day
of the plan year is entitled to the top heavy minimum contribution.
How to Avoid Top Heavy Contributions in a 401(k) Plan
Here are a couple of strategies that can be utilized to avoid the top
heavy contribution requirement in a 401(k) plan.
Key employees can choose not to participate if the plan is top heavy. If
no key employee receives a contribution or forfeiture allocation, then top
heavy contributions are not required. This strategy not only serves to
eliminate the contribution requirement but also is likely to reduce the key
employee top heavy percentage over the years, assuming that non-key
employees continue to contribute (investment results and employee
terminations also play a factor).
It's possible that after a few years of not participating, the key
employee percentage will drop below 60%, resulting in the plan not being top
heavy for one or more years and allowing key employees to resume
participation.
Another strategy is for one or more key employees to take an in-service
distribution from the plan, if allowed under the terms of the plan. This
option is less effective since in-service distributions over the last five
years must be added back when calculating the top heavy ratio. But after
five years, such distributions are ignored, potentially resulting in the
plan falling out of top heavy status for many years.
Keep in mind that in-service distributions may be unnecessary where the
key employees choose not to participate because after five years of not
contributing the plan may no longer be top heavy even without such
distributions.
The Safe Harbor Alternative
Certain salary deferral plans that provide minimum contributions and meet
an annual notice requirement are exempt from the top heavy rules and are
automatically deemed to pass the annual ADP (actual deferral percentage) and
ACP (actual contribution percentage) nondiscrimination tests. This only
applies if additional employer contributions above the safe harbor limits
are not made to the plan. Such plans may actually require the employer to
contribute less than the top heavy minimum. They include:
SIMPLE 401(k) Plan
This is a good compromise for many employers with 100 or fewer employees.
The employer must contribute 2% of compensation to all participants earning
at least $5,000 or make a matching contribution of 100% of deferrals up to a
maximum of 3% of compensation. No other contributions are allowed and all
contributions must be fully vested. Participants of this plan may not
receive any contributions or benefit accruals under any other plans of the
employer.
SIMPLE 401(k) plans have lower contribution limits. Instead of the
current $17,000 deferral limit, plus $5,500 catch-up limit for those age 50
and over, participants in a SIMPLE 401(k) plan can defer up to $11,500 plus
$2,500 as a catch-up ($14,000 total).
The 2% contribution requirement is less than the 3% top heavy
contribution. In plans where the employer is already making some matching
contribution this might not represent a big increase. And the reduced
deferral limit may actually be higher than what HCEs could defer under the
ADP test. This alternative works very well for some employers.
Safe Harbor 401(k) Plan
This plan allows the same deferral limit as a regular 401(k) plan
($17,000 plus $5,500 catch-up), but requires slightly higher employer
contributions than the SIMPLE 401(k) plan. The employer must make either a
3% contribution for all participants or a matching contribution of 100% of
the first 3% of compensation deferred, plus 50% of the next 2% of
compensation deferred (maximum match of 4% of compensation).
There are some differences between a 3% top heavy and a 3% safe harbor
contribution which should be considered. For example, the top heavy
contribution is required for non-key employees still employed at the end of
the year whereas the safe harbor contribution is required for non-HCEs who
were eligible at any time during the year (although HCEs are often
included). Safe harbor contributions must always be fully vested but top
heavy contributions can be subject to a vesting schedule.
Qualified Automatic Contribution Arrangements (QACA)
Salary deferral plans that provide a minimum matching contribution in
conjunction with an automatic enrollment feature can also be exempt from the
top heavy rules and ADP/ACP testing. Participants are automatically enrolled
in the plan unless they elect not to participate. The default contribution
rate escalates each year. Deferrals are matched at a rate of 100% of the
first 1% of compensation deferred, plus 50% of the next 5% of compensation
deferred (maximum match of 3.5% of compensation).
As an alternative to the matching contribution, a QACA can provide a 3%
employer contribution similar to the safe harbor 401(k) requirement. Safe
harbor contributions under a QACA must be 100% vested after the completion
of two years of service.
Conclusion
The top heavy provisions can have surprising consequences for 401(k)
plans, particularly in smaller companies, resulting in the liability for
additional employer contributions. Certain strategies can help avoid such
contributions and take the plan out of top heavy status.
The safe harbor alternative also requires minimum contributions but lets
the plan eliminate ADP/ACP nondiscrimination testing. Accurate employee
information is important for proper top heavy determinations.
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